Section 1031, once a very unfamiliar concept, is now being discussed by people from all walks of life, whether they are stay-at-home moms, heads of companies, regular employees, Realtors, and even working college students. But what is it, really?

An IRS Code 1031 exchange refers to the act of exchanging, or swapping of one business or an investment asset, for another that is exactly the same, or similar to it in value or in nature. These exchanges are typically taxable, but the section allows you to have exceptions, which means that you will either enjoy a limited tax, or none at all at the time of the exchange. What this further implies is that you can, therefore, change the form of your investment without having to cash out a capital gain.

Here is another example to explain the concept further. Let’s say you decide to sell your business or a property that you have invested on. You inevitably gain something from that sale, and by law, those gains are taxable. IRS Code 1031 allows you to postpone the tax payment on that gain if you decide to invest the proceeds in a property or venture that is similar to the one you just sold. Keep in mind that whatever gain you defer in a like-kind exchange under section 1031 is not tax-free, but it is tax-deferred.

The law does not impose any limit or frequency on how often you can do a 1031. For realtors, this means that you can just roll over the gain from a real estate investment to another, and another, ad infinitum. This lets you avoid paying taxes until you eventually sell for cash – even if you gain profit for every swap. You will only pay tax once at a long-term capital gain rate. Sounds good, right?

Too good to be true?

Postponing the payment of a large amount of money, especially if it is tax-related, while you gain profit, surely sounds like it is too good to be true. For IRS 1031 code exchanges, depreciable property exchanged can trigger a depreciation recapture. These properties are taxed as ordinary income. Where do these taxes apply, you may ask? You get taxed if you swap an improved land for, say, a building, or a land that has not been improved and does not have a property or building built on it.

Definition of like-kind exchanges, and which properties qualify

A Section 1031 exchange takes place when properties get exchanged or swapped, with the simplest form being a simultaneous swap of one property for another property. To qualify as an exchange under this code, deferred exchanges must be clearly differentiated from that of, say, a taxpayer who is selling a property and simply using the proceeds from that sale to purchase another property. This type of transaction is taxable. Deferred exchanges happen when the condition of the relinquished property and that of the property being replaced are mutually dependent parts of a transaction.

Properties that qualify for a like-kind exchange must be used for trade or business, or as an investment. Those that you acquire for personal use, such as a condo unit or a primary residence, do not qualify for this type of exchange.

For them to qualify as “like-kind,” they must be similar enough and should be of the same nature or character or the same class. The quality of the property is usually not taken into consideration. Real estate properties must be like-kind to other real estate, such as a piece of vacant land to that of a real property that has a residential rental house. Improvements that do not involve a parcel of land do not classify as like-kind to a land property. The rules, however, are liberal, which means you can exchange one business for another business of a similar nature.

Delayed exchanges and replacement properties

Although swapping one property for another similar property between two parties sounds simple enough, the reality is that it can be extremely difficult to find another party who was the exact property that you want and is also after the exact property that you are looking to swap. This is why majority of exchanges are delayed. Delayed exchanges require the intervention of a middleman who is responsible for keeping your cash until you are able to sell your property. The middleman then uses your cash to purchase the replacement property for you. This exchange, which is classified as a three-party exchange, qualifies as a swap and falls under the provisions of Section 1031.

Keep in mind, however, that timing is everything when it comes to delayed exchanges. Once your property gets sold, you are not allowed the cash – only your middleman does. Receiving the money yourself disqualifies you from the tax exemption and ruins the 1031 treatment. You are also required to designate replacement property in writing to your middleman within 45 days of the sale. You need to specify clearly, in a written document, what property you want to acquire. Delayed exchanges also require you to close on the new property within 180 days from the sale of the old property. You start counting when the sale of the property closes.

The good news is that you are allowed to designate up to three properties as the replacement property, with the condition that you eventually close on any one of these properties. You are allowed to designate more than three if you qualify for certain valuation evaluations. This applies if your replacement properties do not exceed a specific percentage of the aggregate fair market value of the properties designated for exchange.

Not for personal use

Grasping the concept of IRS Code 1031 exchanges can be difficult and confusing, but perhaps the most important thing you need to remember is that this is not for personal use. You are not allowed to swap residential properties, and to a certain extent, vacation homes, unless you turn it into a rental home (which is still tricky). It goes without saying that you cannot swap the home that you live in for another, upgraded home.

To better understand IRS Code 1031 exchanges, it is best to consult a professional.

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